Friday, March 2, 2018

“The Academic Agent” has a video here on what he calls “Six Key Lessons from Classical Economics” (but actually from both Classical and Neoclassical economics):

Of course, not all of his points are wrong. And, since I assume various followers of “Academic Agent” will read this, let me state: I support Post Keynesian economics, a non-neoclassical version of Keynesianism.

But let us break this down as follows, point by point:

(1) “Wealth is not Money”.

This is true. Money is clearly not wealth (if we understand by “wealth” the good and services we consume). Money cannot be consumed in the way that commodities can. Libertarians are fond accusing Keynesians of saying that “money is wealth” or that “money creation is wealth creation.” But I can’t even recall seeing any left heterodox economists who even say this. The maxim that money is not everything – which many people on the Left are fond of saying – is even a subtle admission of the point.

One can readily agree that money is not wealth. Money is (1) a unit of account, (2) a medium of exchange and (3) a store of value.

So this point, while true, is largely a straw man, if it is supposed to be directed against Keynesian economists.

While there are numerous economic activities in modern capitalism that are indeed not zero sum games, there clearly do exist economic activities which are precisely that.

Many speculative activities are like this: for example, activity on secondary financial asset markets where two (or more) parties engage in a trade in which one loses and the other gains. If I “bet” on a futures option or on a currency trade, I win or lose. This is a type of zero sum game.

It is notable that “The Academic Agent” doesn’t even bother to discuss financial markets, which are a fundamental part of modern capitalism.

Furthermore, if a person goes to a casino and gambles (which is clearly a form of capitalist exchange), he wins or loses. Either he comes out with more money than he went in with or less. This is a zero sum game. One could argue that, even if a person loses, he got in return the possible thrill of winning.

But this is a specious argument, because one can also point out that gambling addicts “lose” not only their money but also social well-being as they experience devastating negative personal and social consequences as the result of gambling problems. Such people are losers, and their gambling is a zero sum game.

Of course, plenty of other economic activities and transactions are not zero sum games, but the point remains.

(3) “International Trade is not a Zero Sum Game.

Once again, while a lot of international trade may well be mutually beneficial, not all trade is.

Ricardo’s argument takes the example of cloth and wine production in Portugal and England. Ricardo’s argument is simple: Portugal can produce more wine by concentrating on the production of wine (where it has a comparative advantage in needing less labour), and import cloth from England, even if (as in Ricardo’s example) it takes fewer labourers to produce cloth in Portugal than in England. The aggregate effect of England concentrating on producing cloth (where its comparative advantage lies in needing fewer workers or labour hours per unit) and Portugal producing wine is that a greater quantity of these commodities can be produced in total, and Portugal and England can exchange them to mutual benefit, instead of producing fewer goods in isolation and autarky.

But this argument contains all sort of unrealistic assumptions, and a fatal flaw in that Ricardo (like other Classical economists) assumed a pre-Marxist Labour Theory of Value.

First, the argument for unrestricted free trade by Ricardo’s principle of comparative advantage requires a number of stated or hidden fundamental assumptions to work properly, as follows:

(1) if a nation focusses on comparative advantage, domestic capital or factors of production like capital goods and skilled labour are not internationally mobile, and will be re-employed in the sector/sectors in which the country’s comparative advantage lies and within that nation;

(2) workers are fungible, and will be re-trained easily and moved to the new sectors where comparative advantage lies.

(3) it does not matter what you produce (e.g., you could produce pottery), as long as you do it in a way that gives you comparative advantage;

(4) technology is essentially unchanging and uniform; and

(5) there are no returns to scale in all sectors.

Assumption (1) doesn’t hold today and what happens is movement of capital under the principle of absolute advantage. By practising free trade a nation could experience capital flight and severe de-industrialisation. This results in a type of race to the bottom for industrialised countries that do not protect their industries. Movement of capital to a place where it has absolute advantage tends to cause de-industrialization in Western countries, as capital moves to nations with the lowest unit labour and factor costs, and higher wage countries experience falling wages, high unemployment and rising trade deficits.

Assumption (2) is plainly untrue.

Assumptions (3), (4) and (5) are utter nonsense.

In essence, Ricardo’s argument ignores the long-run benefits of industrialisation (a sector which gives increasing returns to scale), and manufacturing and industrialisation are the only real way to escape the grinding rural poverty of underdevelopment (unless of course you are lucky enough to be one of the minority of nations that has lucrative commodities like energy, or to be some tiny city-state that can get by on service industries).

In the long run, Portugal is better off producing cloth and other manufactured goods, not just wine. By adopting free trade, Portugal will reduce its future aggregate output and reduce its future per capita wealth.

Finally, there is also another devastating flaw in Ricardo’s argument: Ricardo actually uses a naive Labour Theory of Value assumption in its argument! (see also Reinert 2007: 301–304 for discussion). To be more precise, one of Ricardo’s crucial arguments in favour of free trade by comparative advantage is based on the idea that specialising in the production of some commodity is inherently better just because of the comparatively lower labour time involved in production. But this is false.

Even if it takes more labour hours and human labourers to produce manufactured goods, in the long run this is a key to becoming rich, whereas dead-end production of commodities with diminishing returns to scale, even if it requires fewer labour hours and labourers, is a path to Third World poverty.

Erik S. Reinert explains the flaw here:

So, quite clearly, international trade can be a zero sum game in that some nations engaging in free trade will lose, in the sense that they will have much lower future aggregate output and lower future per capita wealth.

It also follows that protectionism may be a better policy to create industries that gave increasing returns to scale (generally manufacturing) – rather than dead-end “diminishing returns to scale,” since this is what marks successful economic development. Once the new manufacturing sectors become internationally competitive, it is possible to reduce or eliminate tariffs. Note also that this policy is perfectly compatible with the fact the other types of tariffs (protecting inefficient rent seekers) or poorly targeted tariffs can be harmful to economic development.

“The Academic Agent” seems to define Say’s Law in two senses, as follows:

(1) you must produce commodities before you consume them, and

(2) supply and demand are not independent of one another, but dependent in the sense that factor payments by producers or income to producers provide the source of demand for other goods.

No serious economist even disputes (1) or (2), and certainly not Keynesians, who would merely add that the creation of credit money within capitalism (for example, by banks) is a further source of demand for goods.

The trouble is that “The Academic Agent” then proceeds to garble Say’s law and what it actually says.

He also seems unaware that historians of economic thought like Thweatt (1979: 92–93) and Baumol (2003: 46) conclude that Jean-Baptiste Say’s role in formulating the law is grossly overrated, and that Adam Smith was in fact the real father of what is recognisably Say’s law in Classical economics, with the major work in developing the idea conducted by James Mill (1808), not Jean-Baptiste Say himself.

Furthermore, Keynes did not misrepresent what the 19th century economists had said about “Say’s Law.”

If we look at how Say’s law was formulated by the Classical economists, as defined by Thomas Sowell (1994: 39–41), it was as follows:

“(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).

It is not clear that (1) is true, since most real-world prices include a profit mark-up and their aggregate value is much higher than the aggregate value of factor payments paid out in the production of the commodities.

Ideas (2), (3) and (6) are ridiculously false, since people can hoard money. In reality, people can hold money without purchasing goods and services. Furthermore, money can be spent on secondary financial or real asset markets where it is not used to purchase commodities.

This will lead to a situation where aggregate output is excessive, since some people do not wish to purchase commodities at all but save their money, hoard it, or spend it on financial assets.

In any real world economy, money from income streams from production, either to capitalists or workers, can become diverted to asset markets and may not be spent on goods. For this reason alone, Say’s law is a grossly unrealistic picture of market economies. Moreover, capitalists themselves have subjective expectations about the future and the future profitability of investment, and when their expectations are shattered, they will not necessarily invest out of retained earnings.

(5) “Every part of the economy is connected to the whole of economy… .”

While this is true, this does not vindicate Léon Walras’ Neoclassical economics, which “The Academic Agent” cites as his source for this insight, which has quite specific assertions about capitalist economies.

“The Academic Agent” argues against government intervention in the economy (by quoting a passage of Thomas Sowell) and tacitly invokes Walrasian Neoclassical theory and Austrian economic theory that envisage a capitalist economy as a self-correcting or self-equilibrating machine, which gravitates towards a long-run general equilibrium state.

But this is a profoundly mistaken view of market economies, and is wrong for the following reasons:

(1) both Austrian and Neoclassical theory ultimately hold that free markets have a tendency towards general equilibrium, and hence economic coordination by means of a flexible wage and price system, and a (supposed) coordinating loanable funds market that equates savings and investment. This is an empirically false view of market economies: it is essentially the product of Marginalists from the 1870s onwards who had physics envy and wanted to model a market economy like a self-equilibrating physical system.

(2) the core Neoclassical and Austrian model in (1) is false because:

(i) market systems are complex human systems subject to degrees of non-calculable probability and future uncertainty, so that market economies would not converge to general equilibrium states even if wages and prices were perfectly flexible. This makes human decision-making highly different to the fundamental model proposed by Neoclassical economics (even with their modern ad hoc models that invoke asymmetric information and bounded rationality), and, even if Austrians supposedly accept subjective expectations in decision making, they fail spectacularly to apply it properly in their economic theory. At the heart of this failure of both Neoclassical and Austrian theory is the mistaken ergodic axiom.

(i) the modern money supply is endogenous because broad money creation is credit-driven (that is, created by private banks and its quantity is determined by the private demand for it), and, furthermore, a truly independent money supply function does not actually exist in an endogenous money world, since credit money comes into existence because it has been demanded, and so the broad money supply is not independent of money demand, but can be demand-led;

(ii) money can never be neutral, neither in the short run nor in the long run.

(iii) the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases, contrary to the direction of causation as assumed in the quantity theory, and

(iv) changes in the general price level are a highly complex result of many factors, and not some simple function of money supply.

(4) the (non-Keynesian) Neoclassicals and Austrians have an obsessive-compulsive fixation with the supply-side, but this cripples their economic theory. In our capital-rich Western economies historically (and once we re-implement some kind of industrial policy now), what mostly constrains our prosperity is the demand-side, not the supply-side.

Once we realise there is no reliable or automatic tendency to general equilibrium in capitalist economies, then nearly all arguments against government interventions to promote economic activity collapse. The whole basis of Neoclassical and Austrian economics collapses.

For example, the assumption of “The Academic Agent” that a government program to build a bridge would automatically destroy private sector jobs, or harm the economy, does not follow at all, and certainly not if we have a recession or depression and vast resources are idle, and there is no private sector impetus for using such idle resources on capital investment or production.

[sc. Keynes’s] ... theory of involuntary unemployment is perfectly simple and can be expressed in a paragraph, or in a sentence. If you express it in a sentence, you simply say that enterprise is the launching of resources upon a project whose outcome you do not, and cannot, know. The business of enterprise involves investment, the investing of large amounts of resources--huge sums of money--in things whose outcome you cannot be certain of, which could perfectly well turn into a disaster or a brilliant success.

The people who do this kind of investing are essentially gamblers and they can lose their nerve. And if they decide to withdraw from trade, they sweep their chips up from the table. If they decide it’s too risky, if their nerve gives out and they can’t bring themselves to go on investing, they cease to give employment and that is the explanation. When business is at all unsettled--when there’s any sign at all of depression--or when there’s been a lot of investment and people have run out of ideas, or when their goods are not selling quite as fast as they have been, they no longer know what the marginal value product of an extra man is—it’s non-existent. How can you say that a certain number of men have a certain marginal productivity when you can’t know what the per unit value of the goods they would produce if you employed them would sell for?”“An Interview with G.L.S. Shackle,” The Austrian Economics Newsletter, Spring 1983.

This is actually a splendid summing up of what Keynes’s theory is about, and why both Austrian and Neoclassical economics are nonsense.

“The Academic Agent” ends with pointing out the “value” in the sense of desiring or evaluating commodities is subjective. This is true, but does not take you very far.

The law of diminishing subjective marginal utility states that, as a person consumes an additional unit of the same good (or a homogenous good), then the satisfaction or utility derived from the consumption of that good diminishes and continues to diminish with each additional good.

As a general empirical principle, it is true, but there are important exceptions, as can be seen here. But this general principle does not refute the case for government intervention in the economy.

Moreover, most prices in modern capitalist economies are not determined by the dynamics of supply and demand, but in reality are cost-based mark-up prices, which tend to be relatively inflexible downwards. Moreover, this is now the overwhelming conclusion of the Neoclassical empirical research literature itself, as can be seen here (with full citation of literature on price determination).

The relative downwards price rigidity in modern capitalism (largely an outgrowth of businesses and corporations themselves trying to avoid flexible price markets) also destroys the whole basis of the correction mechanism envisaged in Neoclassical and Austrian economics, since they think that product markets have a tendency to clear by highly flexible prices, when in reality this is confined to a minority of markets.

Regarding Ricardo and comparative advantage, what about the modern formulation based on opportunity cost rather than the labor theory of value?

https://en.wikipedia.org/wiki/Comparative_advantage

"In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.[3] One does not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries."

"In 1930 Gottfried Haberler detached the doctrine of comparative advantage from Ricardo’s labor theory of value and provided a modern opportunity-cost formulation. Haberler’s reformulation of comparative advantage revolutionized the theory of international trade and laid the conceptual groundwork of modern trade theories.

Haberler’s innovation was to reformulate the theory of comparative advantage such that the value of good X is measured in terms of the forgone units of production of good Y rather than the labor units necessary to produce good X, as in the Ricardian formulation. Haberler implemented this opportunity-cost formulation of comparative advantage by introducing the concept of a production possibility curve into international trade theory.[15]"

If a production facility moves then wherever the production facility ends up has to take either your new output, or your money in return for the new increase in imports to you. And the currency moves accordingly.

If they don't take your stuff or your money, then you won't get the exports and some new firm can produce the element locally instead.

So if Nissan move from the UK to the EU they have to export Nissans they sell here to us and the EU overall has to take our output or our money (which is free to produce). The workers won't move though, so the UK could just hand them over to Mr Dyson with a very cheap working capital loan to start producing a competitor.

Comparative advantage assumes that you can transform a wine press into a spinning jenny within a nation, when in fact they are more likely to flow between nations these days.

The Capital of a nation is the skills of the people within it. They tend to stay home, because most people like to live in an area rather than wander the globe looking for their next gig.

The Specialisation theories of trade still think we operate with interchangeable labour units. It's straight out of the 1930s.

LK,You seem to support the opinion that the demand for money in our contemporary system creates supply and not the other way around.What I would like to ask you if you would be willing to take a credit with 50% interest? I am asking because it is the interest that determines if people would like to apply for a credit or not. But the interest depends on the amount of money available in the banks. When banks have much money they lower the interest rates, when not they raise them. So, it is again up to the amount of money in the bank that determines how much credit is created. In other words: The supply of money creates demand (i.e. Say's law), not the other way around (as you claim).

As a side note: You seem to take the contemporary monetary system as given (i.e. an axiom) and start from there. Austrians do not. But when and if you manage to drop some of your core assumptions you may be able to see the situation from a different perspective.

The willingness to take such a credit would also depend on expectations regarding future prices, wages and profits would it not ?With a very high inflation you might crave for such a credit provided you need them to fuel your company, pay wages and produce goods you intend to sell at higher and higher prices.(And to prevent the objection that inflation itself stems from too affluent money etc. it might very well be a political response to a reprartition conflict between capital and organised labor. At least it is one explanation of inflation during the 70')

Of course willingness depends on many things. For instance on the amount of interest you have to pay. As I said before if one has to pay back a loan with 50% interest one would think twice before taking it. When banks see a growing demand for their financial products they raise prices (interest). And when they have lent out most of the money that they have they raise the interest even higher.

In short: people cannot get more money than there is in the banks. It does not matter how much they crave money when the money itself is limited.

Your argument takes the stock of money as a pre-existing, finite amount to which debtors are trying to get access. That is incorrect. Banks operate off of double-entry bookkeeping; that is the basic practice that underpins all of finance. The essence of double-entry bookkeeping is that a new loan creates new deposits. Loans are not taken out of a pre-existing stock at all--that stock is created by promises by debtors to take on new loans. The promise to take on a loan is what allows new interest-bearing debt to be created.

This is also what dictates interest rates. When reliable debtors are scarce, the banks will demand more interest on the money they lend out--a reflection of a diminished supply of people willing to take on loans. When reliable debtors are numerous, the price of debt declines as banks compete for an expanding supply of customers.

The notion that banks contain a fixed supply of money which dictates financial conditions to debtors is completely at odds with the most basic practices of accounting upon which finance and banking operates.

The stock of hard (base) money in the banks is fixed. It cannot be expanded unless the central bank decides to increase it. But yes, banks may multiply this stock of money. For instance with a 10% reserve requirement and 1 million base money in the banks they can produce up to 10 million (monetary multiplication). But this is the limit. They cannot produce more since they are limited by the banking laws. Even if this minimum reserve requirement did not exist they would still need to keep some money to cover the normal withdrawals (let us say 1 %). So, even in this limiting case they can create 100 million maximum. But as you see they cannot create more. They still have a limit. Unless the central bank increases their reserves banks will expand the monetary supply up to 100 million and stop (forever!). That is why the supply of money determines how much money can be lent (i.e. supply creates demand). It is an inescapable physical law.

I had a question about investment and (un-)employment and Shackle / Keynes' view of it :they seem to explain involuntary employment in an essentially psychological way (losing one's nerve). Other authors like Kalecki (and more recently Streeck) argue that investement is also a political matter and to some extent a weapon. Refusal to invest is a kind of capital's strike.